Young Americans: The Death of Equities May be Exaggerated

Tuesday, August 21st, 2012

August 20, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• PIMCO founder Bill Gross believes the “cult of equity is dying” … let me take the other side.
• Mutual-fund flows suggest that we may have lost a generation of investors.
• However, demographics suggest there may be another generation that could be the stock market’s savior.

Rumors of the death of equities may be greatly exaggerated. Bill Gross, founder of PIMCO, recently wrote that the “cult of equity is dying,” and of course it generated a furor of interest. In a separate Tweet, Mr. Gross noted that disillusion with stocks “might be a generational thing.” I have great respect for Bill and was very fortunate to share the stage with him at the opening of last year’s Schwab IMPACT conference. He was no more optimistic then than he is now and several media outlets that covered the conference called me the “optimistic ying to his pessimistic yang.”

Bill’s recent comments didn’t do much more than repeat the view he’s held for some time. I remember reading back in February 2009 an interview he did with Forbes Magazine in which he opined, “…things will never be the same. Risk taking has been destroyed and any animal spirits must come from Washington. Global growth rates—low, low, low—asset classes will be readjusted for that outlook. That is—stocks will be more of a subordinated income vehicle as opposed to a ‘stocks for the long run’ growth vehicle.”

Not just a lost decade … a lost “baker’s dozen”

Needless to say, the timing of those comments was not ideal as the stock market bottomed the following month and has since doubled. This missive is by no means an attempt to discredit Bill or his views, as there’s a lot of truth to what troubles him. Frankly, they’re the same truths that continue to plague the psyche of the majority of individual investors that are indeed shunning stocks as if the recent lost decade (or, more precisely, lost “baker’s dozen” given that the S&P 500 index is presently at levels equivalent to where it traded back in 1999) will be repeated.

I know that this opinion may elicit many of the same comments I’ve heard following other contrarian views I’ve expressed over the past three years—that I’m yet another “perma-bull” with blinders masking long-term structural problems that will forever plague stocks. First, I’m not a market timer, but I’m also not a perma-bull. Long-time clients may recall we were decidedly pessimistic about the outlook for both the economy and stock market leading into the 2007 top and didn’t turn optimistic until the spring of 2009.

I remain optimistic longer-term, albeit it with near-term concerns due to the obvious pressures still with us thanks to the ongoing eurozone crisis, the looming US fiscal cliff and related election uncertainty, and slowing global growth. But it’s the longer term that’s the focus of today’s report.

Being a contrarian

I’m never a contrarian just to be contrarian, but sometimes tacking against the winds of the market and investor psychology can be amply rewarded. Stock market sentiment has always been driven by what the market has done in the past, not by a fundamentally based consideration of what might lie ahead.

Short-term sentiment measures will always ebb and flow with market action, but most longer-term sentiment measures show a level of despair about stocks unmatched in the post-World War II era. One need look no further than mutual-fund flows: the chart below shows a $1.4 trillion spread between bond-fund inflows and stock-fund outflows—a spread unmatched in history.

An Unprecedented Show of Risk Aversion

Source: FactSet, Investment Company Institute, as of June 30, 2012.

A wave of shocks

The inflows to bond funds are easy to explain given strong returns (until recently). But they’re also characteristic of aging Baby Boomers’ risk aversion and reactions to a veritable wave of shocks to both the system and investors’ psyche, including, but not limited to:

• The lost decade (or as previously mentioned, the lost “baker’s dozen”)
• The dramatic decline in the stock market from 2007 to 2009
• Periods of unprecedented market volatility
• The 2010 “flash crash”
• The growing dominance of high-frequency trading and its effect on market behavior
• The 270-point average daily Dow swing in 2011′s August-November span related to Standard & Poor’s downgrade of US debt and the debt-ceiling debacle
• Facebook’s disastrous initial public offering and subsequent price performance
• JP Morgan’s huge trading loss earlier this year
• Another Ponzi scheme in the form of Peregrine Financial Group (and related attempted suicide by its founder), coming on the heels of the Bernie Madoff and Allen Stanford scandals
• The “LIBORgate” rate-setting scandal

The bottom line is that the demise of interest in stock investing by many individual investors is in very large part due to a total lack of trust in the transparency and fairness of the market. This is understandable.

I often get asked whether there’s any hope for the market longer-term if individual investors remain on the sidelines. History may be a guide. As noted by The Leuthold Group this spring, there were two stock market climbs the public missed. The first was the advance from 1974 to 1980, which lasted more than six years and amounted to a 120% gain for the S&P 500, and a multiple of that gain in small-cap stocks. However, US-focused mutual funds enjoyed net inflows in only 15 months during this run. The shallow bear market of 1976-1977 likely shook out many would-be buyers … and contrarians might note the high of that entire move coincided with the first sizable month of net inflows.

More recently, during the current cyclical bull market (since March 2009) there have been two sharp declines in both mid-2010 and mid-2011. They probably served the same purpose as the 1976-1977 decline—scaring off many retail investors just as they were finally preparing to tiptoe back in. It’s hard to fathom that a majority of individual investors could remain sidelined in the face of a continued strong rally in stocks, but the late 1970s showed that it can happen.

Back to demographics and the “Millennials”

In history, few forces have been as strong behind stock returns as demographic trends: movements in population, age, gender and employment status, among others. Much focus has been on Baby Boomers, especially as they begin to retire, and their effect on markets in the future. Yes, they’re now more risk-averse than ever, and this is not likely to change. But what about a key generation behind them?

Those born after 1980 are generally considered “Millennials,” but I prefer the description “Echo Boomers,” as they represent many of the children of Baby Boomers. Millennials are often characterized as having less financial savvy and weaker job prospects than their Boomer parents. The result is an impression of a generation equally as disenfranchised from the stock market as the Baby Boomers.

However, I think many may be underestimating the positive impact this generation may have on investing trends. I recently read an interesting report on the subject by Turner Investments in which it noted that the Millennials are “digital natives”—the first generation raised with technologies such as personal computers, the Internet and smartphones that prior generations had to adapt to later in life.

My two children (ages 12 and 16) can’t fathom that I had to rely on libraries, books, encyclopedias and a typewriter when I was a college student. But they’re part of a generation that’s become completely reliant on “new” technologies. Eight of 10 of Millennials sleep with their cell phones in reach (count my kids in the 20% that don’t, though they would if we let them).

The Millennials are highly educated: About 40% of college-age Millennials are enrolled in higher education—the greatest percentage in US history. Yes, some of that’s a result of the rough economic ride they’ve been on over the past decade or so. They’ve had to suffer two economic/market crises since 2000, starting with the bursting of the technology bubble and followed by the bursting of the housing bubble and the attendant financial crisis. The dearth of jobs has hit the generation particularly hard. About a third of 18-29 year olds are unemployed, under-employed or simply out of the work force.

Don’t underestimate the Millennials

Turner offers seven reasons why the financial prospects of Millennials may be much better than is popularly supposed and why Millennials may “bring about a Great Bull Market of the 21^st Century”:

1. The Millennial generation is huge at more than 85 million—even larger than the Baby Boomers’ 81 million. It wasn’t until Boomers were in their 30s that they began to truly make their presence felt in the stock market. The great bull market of the last century was the result. My additional perspective: vehicles like 401(k)s make it easier and more “automatic” for this cohort to invest.
2. Millennials’ financial struggles thus far are actually fairly typical of early adult life: paying for education, finding a first job, relocating, buying a first house and learning the vocational ropes.
3. Macroeconomic headwinds facing Millennials—notably high unemployment and depressed housing—are likely to be temporary. My additional perspective: housing has likely already found its bottom and household formation has jumped significantly since its lows.
4. Baby Boomers once faced similar macroeconomic headwinds (during the late 1970s and early 1980s), but were still able to subsequently invest in stocks and drive the market to new highs during their peak earning years.
5. Despite all of their financial troubles, Millennials are savers and are already investing in stocks. Twenty-something investors have more stocks in their 401(k) accounts today than their counterparts did a decade ago, according to the Investment Company Institute. About 80% of 20-somethings had devoted at least 60% of their 401(k)s to stocks in 2010 (the latest year of data) versus 70% in 2000.
6. Millennials tend to be optimists and are more willing to take risks relative to their parents’ generation. About 29% of all entrepreneurs are Millennials, according to the Kaufman Foundation, suggesting an appetite for risk.
7. Millennials are putting emerging nations in a demographic sweet spot. The ratio of workers to the total populace in East Asia rose from 47% in 1975 to 64% in 2010. In Latin America the ratio rose from 44% to 56%, and in South Asia it rose from 45% to 55%. A sizable new class of investors is surfacing around the globe.

Food for thought.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Copyright © Charles Schwab and Company

Tags: Animal Spirits, Asset Classes, Bill Gross, Charles Schwab, Chief Investment Strategist, Disillusion, Forbes Magazine, Founder Bill, Furor, Global Growth, Impact Conference, Individual Investors, Liz Ann, Media Outlets, Missive, Mutual Fund Flows, Risk Taking, Senior Vice President, Tweet, Young Americans
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China Cuts RRR By 50 bps Despite Latent Inflation To Cushion Housing Market Collapse

Saturday, February 18th, 2012

It was one short week ago that both Australia surprised with hotter than expected inflation (and no rate cut), and a Chinese CPI print that was far above expectations. Yet in confirmation of Dylan Grice’s point that when it comes to “inflation targeting” central planners are merely the biggest “fools“, this morning we woke to find that the PBOC has cut the Required Reserve Ratio (RRR) by another largely theatrical 50 bps. As a reminder, RRR cuts have very little if any impact, compared to the brute force adjustment that is the interest rate itself. As to what may have precipitated this, the answer is obvious – a collapsing housing market (which fell for the fourth month in a row) as the below chart from Michael McDonough shows, and a Shanghai Composite that just refuses to do anything (see China M1 Hits Bottom, Digs). What will this action do? Hardly much if anything, as this is purely a demonstrative attempt to rekindle animal spirits. However as was noted previously, “The last time they stimulated their CPI was close to 2%. It’s 4.5% now, and blipping up.” As such, expect the latent pockets of inflation where the fast money still has not even withdrawn from to bubble up promptly. That these “pockets” happen to be food and gold is not unexpected. And speaking of the latter, it is about time China got back into the gold trade prim and proper. At least China has stopped beating around the bush and has now joined the rest of the world in creating the world’s biggest shadow liquidity tsunami.

First, here is a chart showing the collapse in the Chinese housing market in all its glory – without a shadow of a doubt the primary reason for the PBOC to do what it did today:

Will the PBOC be able to redirect the “Austrian” money flow into ponzi encouraging prospects? Here is Sean Corrigan with some thoughts:

Chinese Real M1 joins that of parts of Europe, the UK, India, and several other, key EM nations in dropping into negative territory and hence strangling the monetary impetus towards both dubious short-term output gains and more certain quickening of the pace of price appreciation which has driven so much of the recovery so far. This means that only the US is left creating sufficient real new money to keep things supported at present – a phenomenon not surprisingly being reflected in its run of somewhat improved macro numbers in recent months.

For China itself, this is unprecedented – at least in the last 15 years or so during which China has assumed the role of marginal buyer of inputs a fortiori – and it represents the latest stage in a jarring, screeching, airbag-triggering deceleration from 2010′s extraordinary 37.5% growth rate. You don’t have to be an Austrian to see what this must imply for all the non-remunerative, hyper-Keyensian, ‘stimulus’ projects launched to offset the Western slump, post-LEH/AIG which litter the Middle Kingdom’s landscape, both figuratively and literally.

While we must be slightly tentative in our inferences – due to the disruptive arithmetical effect of that highly moveable feast which is the Lunar New Year – it cannot be denied that several other indicators – imports, container traffic, power consumption, for example – are also flashing Hard Landing Red here.

Watch this space…

Here is the MSM take on today’s event via Reuters:

China’s central bank cut the amount of cash banks must hold in reserves on Saturday, boosting lending capacity by an estimated 350-400 billion yuan ($55.6-$63.5 billion) in a bid to crank up credit creation as the world’s second-biggest economy faces a fifth successive quarter of slowing growth. The People’s Bank of China (PBOC) is on the course of gentle policy easing to cushion the world’s fastest-growing major economy against stiff global headwinds as Europe’s debt crisis grinds on, although it has been treading warily.

The PBOC cut big banks’ reserve requirement ratio (RRR) by 50 basis points to 20.5 percent, effective from next Friday, after repeatedly defying market expectations for such a move after it first cut the ratio last November.

“It’s not a big surprise. Although they (Chinese leaders) stress policy stability, an RRR cut is necessary. Trade and monetary data in January pointed to some downward pressure on the economy,” said Hua Zhongwei, an economist at Huachuang Securities in Beijing.

“But policy easing will be gradual given the central bank sounded cautious about inflation in its fourth-quarter monetary policy report.”
…

Slower growth also has ramifications for the world economy — already hampered by decaying demand from debt-ridden Europe and still under-spending U.S. consumers — given that China now adds more each year to net global growth than any other nation.

China’s leader-in-waiting, Xi Jinpeng, assured an audience of business executives in Los Angeles on Friday that China’s growth would not falter it would continue to rebalance its economy to import more from other countries.

“There will be no so-called hard landing,” said Xi, who is almost sure to succeed Hu Jintao as Chinese president in just over a year, on the final day of his tour of the United States.

The central bank announced its first cut in RRR in three years on Nov. 30, 2011, taking the rate down by 50 bps.

Investors had expected another RRR cut ahead of the Chinese Lunar New Year in late January, but they were wrong-footed as the central bank opted for open market operations to provide short-term cash for banks.

More meaningless RRR cuts coming?

“We still see four more RRR cuts in the remainder of the year,” said Shen Lan, an economist at Standard Chartered Bank in Shanghai. “The central bank may still stress policy stability. The next cut should be in Q2.”

Oh well, if the perception of encouraging inflation is what the PBOC wants, the perception of encouraging inflation is what the Chinese gold bugs get.

Tags: Animal Spirits, Austrian Money, Beating Around The Bush, Bps, Brute Force, Central Planners, Corrigan, CPI, Gold Trade, Grice, Housing Market, Market Collapse, Michael Mcdonough, Money Flow, Pboc, Reserve Ratio, Shadow Of A Doubt, Shanghai Composite, Time China, Uk India
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“New Normal” is Morphing into “Paranormal,” argues Gross

Thursday, January 5th, 2012

In his latest edition of his monthly newsletter, Bill Gross waves goodbye to the “New Normal” and adopts the “Paranormal”.

The following are a few excerpts from the report:

The New Normal, previously believed to be bell-shaped and thin-tailed in its depiction of growth probability and financial market outcomes, appears to be morphing into a world of fat-tailed, almost bimodal outcomes.

A new duality – credit and zero-bound interest rate risk – characterizes the financial markets of 2012, offering the fat left-tailed possibility of unforeseen policy delevering or the fat right-tailed possibility of central bank inflationary expansion.

The critical question of course is whether efforts by the ECB, BOE, and Fed will work. Can they reinvigorate animal spirits in the face of “credit” and “zero bound money” risk? We shall see. An investor however should hedge his/her bets until the outcome becomes more obvious.

Bond Markets

1. Durations and average maturities should be at their maximum permissible limits. Even if reflation is successful it will only be because the Fed and other central banks keep policy rates low for an “extended period of time.” Financial repression depends on negative real yields and until inflation moves higher for a period of at least several years, central banks will hibernate at the zero bound

2. The bulk of sovereign bond holdings should be in the U.S. as long as Euroland credit implosion is possible investors should gravitate to the “cleanest dirty shirt” sovereigns with the least encumbered balance sheets. Anything short of a 5-year maturity however yields relatively nothing and provides minimal rolldown. Focus on 5–9 year Treasury maturities to guard against inflation which create opportunities to take advantage of rolldown capital gains.

3. Long Treasury maturities should be held in TIPS form.  If inflation really is coming, then an investor will want assets that offer inflation-protection.

4. Corporate credit purchases should be in higher-rated   A and AA paper. Senior as opposed to subordinated holdings in finance/bank debt should be considered as well. Haircuts ahead?

5. U.S. municipals represent an opportunity from the stand point of valuation. Their yields of 5–6% are near historically high ratios to Treasuries. They do, however, entail risk – not only volatility but occasional default risk. This is not a Meredith Whitney echo but simply a recognition that you usually get what you pay for in this world and nothing comes for free. Be selective and avoid states/municipalities with pension and funding problems.

6. Continue to avoid Venus fly trap peripheral Euroland paper. Italian bonds at 7% for instance are enticing but have trap door possibilities that could see further “price” defaults in 2012.

Stocks and commodities

1. Stocks yield more than bonds and will tend to do better in anything but a delevering fat left tail. That, however, is what worries us. Equity allocations, therefore should favor higher yielding companies in sectors with relatively stable cash flows: Electric utilities (yes they appear overbought), big pharma and multinationals should head your shopping list.

2. Commodities could go either way depending on the tails but scarcity and geopolitical considerations (Iran) favor a positive tilt. Gold at $1,550 seems pricey but it has upward legs if QEs continue.

Currencies

The dollar is king with a left-tailed delevering scenario – pauper in a right-tailed global reflationary expansion.

Summary

For 2012, in the face of a delevering zero-bound interest rate world, investors must lower return expectations. 2–5% for stocks, bonds and commodities are expected long term returns for global financial markets that have been pushed to the zero bound, a world where substantial real price appreciation is getting close to mathematically improbable. Adjust your expectations, prepare for bimodal outcomes. It is different this time and will continue to be for a number of years. The New Normal is “Sub,” “Ab,” “Para” and then some. The financial markets and global economies are at great risk.

Click here for the full article.

Bill also shared his views in the following interview with The Wall Street Journal:

Source: Bill Gross, PIMCO – Investment Outlook, January, 2011 and The Wall Street Journal, January 4, 2012.

Tags: Animal Spirits, Balance Sheets, Bimodal, Bond Holdings, Bond Markets, Capital Gains, Central Banks, Critical Question, Depiction, Dirty Shirt, ECB, Financial Repression, Implosion, Inflationary Expansion, Interest Rate Risk, Market Outcomes, Maturities, New Duality, Permissible Limits, Sovereigns
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The Fed Twists and the Market Turns (Sonders)

Wednesday, September 28th, 2011

The Fed Twists and the Market Turns

Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
September 22, 2011

Key points

• The Federal Reserve announced “Operation Twist,” which was largely expected, but did little to calm markets.
• The goal is to further reduce borrowing costs and push money via lending out into the real economy.
• Whether it will work is the big question … because high interest rates are not the economy’s problem.

(The bulk of the article below was penned immediately after the Fed’s announcement of “Operation Twist” on September 21, but the following 11 paragraphs add fresh perspective on the recent market action.)

Stocks, commodities and even gold prices tanked the day after the Federal Open Market Committee’s latest policy meeting concluded, adding fuel to the notion that the confidence crisis is reaching new heights. Often the goal of a Fed that’s easing monetary policy is to stir up animal spirits, but instead its move and more pessimistic outlook only added to the lack of confidence about the future health of the economy.

Adding to the woes is the continued meltdown in the eurozone, leading investors to exit all forms of risk and head to the safety of cash and US Treasuries. This has spurred a rally in the US dollar, which, given the recent inverse correlation between the dollar and stocks, has also exacerbated the market sell-off (in commodities, too). In short, the market is coming to the realization that there’s only so much the Fed can do.

Not helping matters were comments from Mohamed El-Erian of PIMCO, speaking at an event in Washington, DC today: He suggested that the world was on the eve of the next financial crisis with sovereign debt its epicenter, and that the European Central Bank hasn’t put in place a “circuit breaker” to contain the region’s debt crisis. This has been our concern for some time now as well, believing a default by Greece is inevitable. Michelle Gibley and I addressed the eurozone crisis in our report last week titled “The End of the Line.”

Lending some credence to the view that the eurozone crisis has become the market’s biggest driver is an analysis of daily trading activity. Based on a study by Birinyi Associates, for the first seven months of this year the primary focus of the US stock market appeared to be the domestic economy, but since August attention has shifted toward foreign concerns.

Through July, the first half hour of trading—when US markets are often reacting to overnight trading in foreign markets—had little effect on the overall returns of the S&P 500. However, since the end of July, if you exclude the first half hour of trading from the S&P 500′s return, the market would be 9% higher than it is now, suggesting the market has become more reactionary to global events and trading.

Even an on-the-surface strong reading in the leading economic indicators out today didn’t ease concerns. Although the LEI was up more than expected, it was driven by the wide yield spread and rising money supply. Both of these financial indicators may be less relevant to growth than in the past: Indeed, every recession in the past 60 years has been preceded by an inverted yield curve (when short-term interest rates are higher than long-term rates); but with short rates pegged at zero, that’s not going to happen. As for money supply, it’s been boosted by fear and lack of confidence as investors of every variety have sold riskier assets in favor of cash holdings—not presently a positive sign.

The strong LEI but weak market action is characteristic of what still remains a somewhat mixed set of indicators. Corporate profits have remained healthy, though earnings estimates have been trending lower. Industrial production and durable goods orders have remained healthy. But macro concerns have taken precedence over some micro positives. And weaker manufacturing growth reported in China yesterday only added fuel to the global slowdown fire.

Finally, there may be another government shutdown pending given the inability to pass a stopgap budget measure that would keep the government running into next month. Just what markets didn’t need is further lack of confidence in political leadership in Washington DC.

We’ve received a lot of questions about the likelihood of a double-dip recession and what the stock market’s saying about the economy. As we’ve often noted, the risk of another recession is certainly elevated, but it’s not yet conclusive. Part of why we think another official recession might be avoided is actually not great news: Many segments of the economy, including small business and housing, never came out of the 2007-2009 recession to begin with, so they may not drop from recent levels sufficiently enough to hurl the economy into another official contraction.

Recessions are defined as sharp declines in activity, but the rebound from the last recession was relatively anemic, suggesting that a sharp decline from these levels is less of a risk. In addition, historically there’s not much difference between the depth of a cyclical bear market that’s accompanied by a recession and one that isn’t followed by a recession.

More troubling is the potentially unique relationship we’re seeing between stocks and the economy. Normally the stock market is a discounting mechanism, and its weakness could indeed be sending a message about future economic growth. But the stock market has also become a catalyst, and its weakness (and the attendant weakness in confidence) could actually be the trigger for another recession … the “self-fulfilling prophecy” concept possibly in play about which we’ve written and spoken, most recently in the latest Schwab Market Perspective.

(Post-Fed meeting comments from September 21):

No doubt in reaction to the significant weakening of the economy over the past several months, the Federal Reserve acted as expected and announced what’s known as “Operation Twist” (OT). The goal of this program, first instituted in 1961 and indeed named after the dance popular at the time, is to lengthen the average maturity of the Fed’s balance sheet. The result, ostensibly, will be to lower longer-term borrowing rates, including mortgage rates.

The details
Specifically, the Fed will buy $400 billion of US Treasury bonds with maturities of six to 30 years through next June. Over the same span, the Fed will sell an equal amount of shorter-term Treasuries, with maturities of three years and less. The Fed also announced that it will reinvest maturing mortgage debt into mortgage-backed securities (MBS) instead of Treasuries. This is intended to help reduce mortgage borrowing costs and stimulate additional mortgage refinancings and demand for new mortgages.

Over the past three months, the value of government agency securities and mortgages on the Fed’s balance sheet has contracted by nearly $40 billion, and the move to reinvest into MBS is to prevent a shrinking of its balance sheet.

My office is adjacent to that of Kathy Jones, our fixed income strategist. We listened to the announcement together, and she had this to say: “The only surprise was that the Fed will shift nearly 30% of its $400 billion in bond holdings into 30-year Treasuries, which is more than most thought would occur at the very long end of the yield curve. This will flatten the yield curve even further. We’ve been using the mantra ‘lower for longer’ … now I guess we’ll have to say ‘lower and flatter for a lot longer’.”

Not everyone’s a fan
As has been the case recently, there were three dissenters on the Federal Open Market Committee (FOMC): Dallas Fed President Richard Fisher, Minneapolis Fed President Narayana Kocherlakota and Philadelphia Fed President Charles Plosser. They’ve been more “hawkish” on recent Fed decisions, concerned about the unintended consequences of extremely easy monetary policy, including inflation.

That said, the statement accompanying the FOMC’s decision did note that “inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks.” The statement did note additional downside economic risks though, specifically mentioning “strains in global financial markets.”

50 years later
Today’s OT has the same rationale as that of 1961—to stimulate a very weak economy while trying to keep inflation at bay. The decision to “sterilize” the purchases of longer-dated Treasuries with sales of shorter-dated Treasuries, thereby keeping the balance sheet at its current size, is an attempt to keep inflation at bay. Recall that both rounds of quantitative easing, QE1 and QE2, did expand the balance sheet and helped unleash a rapid acceleration of commodity inflation. The Fed had been very transparent about its desire to prevent the unintended consequences of more quantitative easing.

What differentiates QE from OT is that OT does not impact the amount of money supply in the markets and therefore the effect on the dollar, and in turn commodity prices/inflation, is more limited. By adding liquidity at the longer end of the Treasury curve and pumping up the supply of Treasuries at the shorter end of the curve, the Fed is hoping that cash will venture into the real economy.

Will it work?
There are risks that the money won’t find its way into the economy and create jobs, as intended by the Fed. Remember, full employment and stable prices are the Fed’s dual mandates. There’s legitimate fear that the Fed’s siphoning of liquidity at the short end of the curve won’t actually lead to increased lending in the real economy. Instead, the move could destroy yields on savings without the beneficial effect on growth, leading to a form of liquidity trap.

We’ve consistently expressed concern that the Fed is unable to cure what ails the economy. The problem is not that interest rates are too high, but that we’re in a debt-deleveraging cycle that started three years ago in the private sector and is only just beginning in the public sector. This will take time—a lot of it—and although the Fed is not impotent, it does not possess the Holy Grail for the economy.

As for housing and mortgage rates, we’re also still in a mortgage deleveraging and foreclosure cycle, and frankly, policy makers may be missing what ails the housing market. The focus has been on getting mortgage rates down further in order to stimulate refinancings and new borrowing. But as I’ve noted many times, it’s the “real” mortgage rate that matters to prospective borrowers, not the “nominal” mortgage rate. What do I mean by that?

The math of “real mortgage rates”
Back at the peak of the housing bubble in 2005, the 30-year fixed mortgage rate (the nominal rate) was about 6%. To get the “real” mortgage rate, you have to subtract the appreciation in home prices (the “deflator”). Home prices were appreciating at a 17% annual rate at the bubble’s peak. So, the real mortgage rate was actually -11%: 6% – 17% = (11%). No wonder we had a bubble … who wouldn’t want to borrow at negative rates? You could borrow at 6% to buy an asset appreciating at 17% per year.

Fast-forward to the trough in housing in 2009. The nominal 30-year fixed mortgage rate had dropped to 5%, but home price appreciation became depreciation at an ironic 17% rate. So, the real mortgage rate was actually +22%: 5% – (17%) = 22%. Who wants to borrow at any rate to buy a rapidly depreciating asset?

I think this is what many policy makers are missing. It’s the “rapidly depreciating” part of the equation that needs to heal. If home prices are still declining, even with rates low, there’s likely to be limited demand to borrow. I do think mortgage refinancings could get at least a marginal lift from OT if rates go lower, but we need to be realistic about the overall affect on housing.

Confidence is key
Ultimately, confidence has to improve before we’re likely to enjoy any reasonable pace of economic growth. Whether this move by the Fed starts the confidence-healing process remains to be seen. But we suggest you keep your expectations relatively low.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Copyright © Charles Schwab and Company Inc.

Tags: Animal Spirits, Bonds, Charles Schwab, Chief Investment Strategist, Commodities, Confidence Crisis, Debt Crisis, Eurozone, Federal Open Market Committee, Future Health, Gold, Gold Prices, High Interest Rates, Inverse Correlation, Lack Of Confidence, Liz Ann, Mohamed El Erian, Open Market Committee, Outlook, Pessimistic Outlook, PIMCO, Reaching New Heights, Senior Vice President, Sovereign Debt
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Could High Oil Prices Cause A Global Economic Deflation?

Friday, April 15th, 2011

by Kurt Cobb, via EconMatters

As the European Central Bank (ECB) prepares to raise interest rates to prevent inflation, the bank cites rising commodity prices, particularly oil prices, as a sign of that inflation. What the bank and other market participants don’t seem to understand is that high commodity prices and, in particular, high oil prices are deflationary.

The logic is so simple it’s hard to understand why smart people with advanced degrees can’t see it. Commodities, particularly oil, pull money away from other sectors of the economy. When people are forced to choose between paying for heat and gasoline or paying the mortgage, they pay for heat and gasoline.

Cars don’t budge without gasoline (unless you can afford an electric one) and most people need their cars to get to work. The heat can be turned off rather quickly by the utility company in comparison to the glacial pace of a mortgage foreclosure that can take many months and sometimes more than a year.

This situation is particularly problematic because it pulls money out of the financial sector. And, despite all the nonsense about the financial industry being on the mend, the industry is actually becoming more and more vulnerable by the day as it increases its exposure and leverage to financial and commodity markets.

The speculative animal spirits of the banks, hedge funds and other large investors, buoyed by all the virtually free money available for borrowing and huge taxpayer-financed injections into zombie banks, may now be hurtling us toward another jaw-dropping financial catastrophe.

As Hyman Minsky might put it, stability and prosperity lead to instability and crisis as market participants become more and more emboldened on the upswing creating the illusion that all is well. Then, when prices and credit expansion go beyond what the economy can sustain, a decline ensues that is often dramatic as confidence suddenly shifts to revulsion and fear.

As housing prices continue to sink, the immense amount of bad mortgage debt still floating around the financial system becomes even more putrid than before. Someday the institutions which hold the debt will have to stop pretending that they are going to get paid back.

However, the prelude to that will be deflation brought on by the high prices of oil and commodities which tend to depress economic activity as household spending is reserved for essentials rather than discretionary items.

As the animal spirits in the markets get dampened by the realities in the economy, the stage is set for a crisis–a turning point when confidence and liquidity turn into fear and illiquidity as big investors try to exit positions all at the same time.

Compounding the deflationary forces inherent in high commodity prices are severe cutbacks by states hit by declining revenues, federal cutbacks, and austerity programs now being implemented across Europe. All of these add to the deflationary juggernaut.

It is certainly possible that commodity prices including oil could rise much higher before the effects described above finally topple the economy. And, it’s possible that those prices could moderate and fall gently in a way that might lengthen any economic recovery under way. But it does seem that we are much closer to a top in commodity prices than to a bottom.

The U.S. Federal Reserve Board seems to agree that high oil prices could be deflationary. One of the Fed governors indicated that the Fed’s attempts to boost the economy by buying government bonds (and thus lowering long-term interest rates) could be extended if oil prices continue to rise.

I don’t know what the interest rate policy for the ECB or the Federal Reserve should be. I think neither have good options. I do know that 10 of the last 11 recessions were preceded by oil price shocks. And, this time, we are dealing with shocks not only in oil, but also in food, just as we did in 2008. And, I don’t have to remind readers what happened after that.

Will we see a repeat of 2008 in 2011? Mark Twain once said that “history doesn’t repeat itself, but it does rhyme.” So far the stanzas of 2011 seems to be rhyming quite well with those of 2008. There have been price spikes in food and oil followed by denials that these could derail the economy coupled with unrest on the streets of many countries related in part to high food and energy costs.

Nevertheless, I’d say look for an unexpected divergence between the two periods. Whether that divergence turns out to be detrimental or felicitous will, however, not change the fact that high commodity prices are deflationary.

About The Author – Kurt Cobb is the author of Prelude, a peak oil-themed novel, and a columnist for the Paris-based science news site Scitizen. His work has been featured on Energy Bulletin, The Oil Drum, 321energy, Common Dreams, Le Monde Diplomatique, EV World, and many other sites. He maintains a blog called Resource Insights.

The views and opinions expressed herein are the author’s own, and do not necessarily reflect those of EconMatters.

Tags: Animal Spirits, Commodities, Commodity Markets, Commodity Prices, Credit Expansion, ECB, Economic Deflation, Financial Catastrophe, Financial Sector, Free Money, Gasoline Cars, Glacial Pace, Hedge Funds, Hyman Minsky, Market Participants, Mortgage Foreclosure, oil, Oil Prices, Revulsion, Sectors Of The Economy, Upswing, Zombie
Posted in Commodities, Credit Markets, Energy & Natural Resources, Markets, Oil and Gas | Comments Off

Warren Buffet: Recession Not Over

Monday, September 27th, 2010

This article is a guest contribution by Trader Mark, of the FundMyMutualFund Blog.

Until we take a break between QE2 and QE3 all discussions of economics and reports will simply be for theoretical and intellectual reasons.  In the end, any market is made up of supply and demand.  If you have a relatively fixed supply of stock certificates (or sugar, coffee, whatever commodity) being chased by an ever increasing amount of fiat money, anyone who took Economics 101 and lasted through day 2 of class knows what happens to price.  The U.S. market was able to rally some 70%+ during QE1 even as Americans actually withdrew (on a net basis) money from the market – so you can see the power of “the not so invisible hand”.  [Jan 6, 2010: Charles Biderman of TrimTabs Claims US Government Supporting Stock Market]

This is the template everyone is working on – again to repeat what I say each time, QE has very little to do with the real economy (don’t believe the lies coming out of that mouth) and everything to do with goosing assets of all types.  Some portion of those gains in paper assets can then be rolled into the real economy I suppose over time via the ‘wealth effect’… so the Fed simply is trying to repeat 1999 NASDAQ as the attempt to repeat 2005-2007 housing looks to be impossible.  (although we are trying mightily with record low mortgage rates, the return of 0% down mortgages – now government sponsored, paying people to buy homes via credits, and the like)

Whatever the case, this mantra has changed psychology and half the battle in the market is animal spirits.  If everyone believes act A will lead to outcome B, then it self reinforces to a great degree.  QE2 has not even begun but everyone is in a rush to front run the perceived asset inflation of all type, hence it has been self fulfilling.  Somewhere Ben is laughing watching the rat’s lemming’s in his lab experiment scurry.  So as I said, anything I post about economics go forward is to be read, processed and then discarded immediately since none of it matters until we take a break from QE2. (which again – has not even STARTED)  At which point Ben can start hinting about QE3 which should get speculators in a lather, front running assets once more… and we can keep this game going forever and ever (and ever!) Who needs a real economy anymore?  Manipulation of assets is so much easier.

To that end today around 10 AM came a very poor existing home sales number.  The market paused for a second… should it react to reality?  Nah, a permanent open market operation of dollars was going to be flooding in the market in 15 minutes, so let’s start a new leg up … and so we did.

(My only question to this “we can’t lose” idea is why did the Japanese stock market not surge to all time highs with the amount of QE they did for a decade+?)

——————————————

This story on Buffet refuting the economy is out of recession is interesting not so much for his words but some of the statistics he gave on his businesses.  The railroad companies are acting as if we are back to 2007 global trade highs (in terms of stock action) but apparently economic activity is still far below peak levels.  That said, does it matter?  There is only so much supply of railroad stock certificates with ever increasing fiat money chasing it… you get the picture right?

• Billionaire Warren Buffett says the economy remains in a recession, by his definition, because most people and businesses still aren’t doing as well as they were before the financial crisis.  Buffett’s assessment of the economy contradicts the view of experts who announced this week that the recession officially ended in June 2009. But Buffett says he uses a commonsense standard to evaluate the economy.
• “On any commonsense definition, the average American is below where he was before, or his family, in terms of real income, GDP,” (gross domestic product) Buffett said on CNBC. “We’re still in a recession. And we’re not gonna be out of it for awhile, but we will get out of it.”
• He said the government is running a federal deficit equal to 9 percent of the nation’s gross domestic product, which is providing quite a lot of stimulus.  ”It doesn’t depend on calling it the stimulus bill to be stimulating. I mean, if the government is spending $3 for every $2 it takes in, that is, that is fiscal stimulus,” Buffett said.

Here are some of the very interesting metrics:

• Buffett gets insight into the health of the economy through the performance of Berkshire’s subsidiaries.   Buffett said Berkshire’s businesses are improving but at a slow rate.
• He said Berkshire’s Burlington Northern Santa Fe railroad, for instance, is probably doing better than many U.S. businesses, and it’s only about 61 percent of the way back to its peak shipping volumes from the bottom of the recession.
• And Berkshire’s Shaw Carpet used to sell about 13 million yards of carpet a week. Buffett said that fell to about 7 million yards during the recession, so Shaw eliminated 6,500 jobs. Buffett said Shaw won’t start hiring back until the business gets back to selling at least 10 million yards a week, and so far it’s only selling about 9 million yards a week.

Copyright (c) FundMyMutualFund

Tags: Animal Spirits, Fiat Money, Half The Battle, Invisible Hand, Lab Experiment, Lemming, Low Mortgage, Mantra, Mortgage Rates, Nasdaq, Paper Assets, Qe, Qe1, Qe2, S Market, Stock Certificates, Trimtabs, Warren Buffet, Wealth Effect
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Merging but Not Surging (Andrews)

Monday, August 23rd, 2010

This article is a guest contribution by David Andrews, CFA, Director, Investment Management and Research, Richardson GMP Ltd.

The seemingly endless stream of increasingly negative economic news and market pessimism was rudely interrupted last week with a series of market friendly merger and acquisition announcements. Intel finally consummated its year and a half courtship of McAfee Inc. in an $8 billion dollar deal for the security software maker. Korean National Oil Corp (KNOC) upped its ongoing hostile takeover bid for Scotland-based Dana Petroleum plc to £1.9 billion. By far, the biggest of the big announcements came earlier last week when Australian mining giant, BHP Billiton, made a splash with an unsolicited bid of $39 billion for Canada’s Potash Corp. The bid was immediately rejected by the Potash board and the stock soared 25% in anticipation of a deal being done at a much higher price.

The key takeaways for investors are that companies, now sitting on almost $3 trillion in cash, are seeing compelling value in the marketplace and are increasingly willing to spend their cash. Low interest rates are also helping fuel what is typically the slowest month for mergers and acquisitions into one of the busiest. The other key take away is that perhaps the flurry of M&A activity will inject a much needed boost to investor confidence. Increasingly bad news on the economic front has been zapping both consumer and investor confidence which has aided in keeping markets range bound. John Maynard Keynes used the phrase ‘animal spirits’ to refer to the psychological motivations that drive both the economy and the stock market. Right now, investors have preferred to keep their animal spirits either on a short leash or in a cage.

The outlook for the U.S. economy continued to deteriorate last week with a report indicating the number of Americans filing for unemployment benefits climbed to 500,000, the highest level since last November. Unemployment seems stuck at 9.5% as companies are frozen in a sea of uncertainty regarding both the economic outlook and the regulatory environment. Another blow to confidence came in a report, known as the ‘Philly Fed’. It showed manufacturing in the mid-Atlantic area shrank in August, possibly suggesting the ISM manufacturing index may drop below 50 – a sign the economy is contracting. The market will turn its focus to July housing data due out this week. We will be looking to see if the rebound in June activity can be maintained. In June, U.S. housing made a strong recovery after the month of May proved to be a disaster. As with most other data points on the U.S. economy this year, housing data has also been inconsistent. Investors will get to reflect on U.S. second quarter GDP due out Friday. It is expected that a growing U.S. trade gap and weaker consumer spending will have shaved roughly one percentage point of growth off the world’s largest economy. The slowdown, initially thought to occur in the second half of 2010 appears to have hit in the second quarter of the year instead. Not to add salt to the U.S. economy’s wounds, it is worth noting China surpassed Japan as the world’s second largest economy capping the Sino nation’s rise from communist isolation to emerging superpower.

Turning to the investment markets, investors continue to be fascinated with both safety and liquidity as concerns about the economic recovery continue to persist. 10-year government bonds posted a fourth consecutive weekly advance as investors anticipate increased quantitative easing by the Fed in an effort to stimulate the economy. Bond bulls shoved the U.S. 2-year note to record low yields in what may be an overreaction to the negative data streaming in on the economy. Over reaction or not, this is the difficult environment investors face today. Indicative of the challenge is the fact North American market indices are seeing convergence of both the shorter and longer term moving averages. This normally indicates an impending change in trend. Think of the coiling of a spring before it is unleashed. The big question is in which direction will it move when it unleashes? More M&A announcements like we saw last week would favour a significant move higher. We know companies are sitting on piles of cash, which are earning next to no return. On the other hand, the bond market is telling us the economy is getting worse and could, for lack of a better term, get worser.

Of course the equity market could choose to follow a third path. We may see the stock market continue to grind for the next number of weeks until a direction changing catalyst emerges. In that environment, we continue to recommend investors stay focused on large-cap, liquid, dividend paying stocks that: a) will offer some form of downside protection in the form of yield support and liquidity b) will also participate should the market decide to break higher from here.

Copyright (c) David Andrews, CFA, Director, Investment Management and Research, Richardson GMP Ltd.

Tags: Animal Spirits, Bhp Billiton, Canadian Market, China, Dana Petroleum, Dollar Deal, Economic Front, Endless Stream, Filing For Unemployment Benefits, Giant Bhp, Hostile Takeover, Investor Confidence, John Maynard Keynes, Knoc, Low Interest Rates, Merger And Acquisition, Mergers And Acquisitions, National Oil, oil, Potash Corp, Psychological Motivations, Security Software Maker, Takeover Bid
Posted in Energy & Natural Resources, Markets, Oil and Gas, Outlook | Comments Off

Animal Spirits and the Economic Outlook

Wednesday, July 7th, 2010

This article is a guest contribution by Dr. Scott Brown, Raymond James Equity Research.

Near-term economic expectations have softened over the last few months and the risks to the growth outlook have become tilted more to the downside. There’s nothing to suggest that a double dip recession is imminent or even likely over the next few quarters. However, the one element that’s hard to get a handle on is psychology. Fears of a double dip could become self-fulfilling if enough firms stop hiring.

The June Employment Report seemed to encapsulate the themes generated by recent economic data releases. That is, the pace of growth appears to have moderated – still positive, but somewhat slower than was anticipated a few months ago. Private-sector payrolls continued to advance in June and the three-month average (+119,000) was respectable, but not especially strong. Prior to seasonal adjustment, private-sector payrolls advanced by 863,000, up by 3.358 million since February. That looks like the kind of (unadjusted) job gains we would see in a normal year, but the pace has been disappointing given the depth of the decline over the last two years.

The unemployment rate fell to 9.5% in June, but the details suggest no significant improvement. The decline was due largely to a drop in labor force participation, which could be a consequence of unemployment insurance benefits running out for some individuals. The employment/population ratio avoids month-to-month peculiarities in labor force participation – it fell further in June (to 58.5%, vs. 58.7% in May, 59.4% a year ago, and around 64% in the late 1990s).

The June jobs report confirms what was widely expected at the start of the year. That is, economic growth was expected to be positive, transitioning to a more sustainable recovery (one supported by an underlying expansion in consumer spending and business fixed investment rather that federal fiscal stimulus and a shift in inventories), but unlikely to be strong enough to push the unemployment rate down by much.

The list of near-term economic headwinds is long: lingering problems in residential and commercial real estate; tight credit, especially for small firms (and some reluctance of creditworthy borrowers to take on debt); the contractionary consequences of tighter state and local budgets; the federal fiscal stimulus ramping down into 2010; the Bush tax cuts expiring at the end of this year; and tighter budgets overseas limiting global growth. On the positive side, long-term interest rates are extremely low, which should provide some support. Thirty-year home mortgage rates hit another record low last week.

One worry is that if the recovery should falter, monetary and fiscal policy may be helpless to counter that. The Fed already has short-term interest rates near 0% – conventional monetary policy is played out. The Fed could resurrect quantitative easing (buying mortgage-backed securities and long-term Treasuries), but what would be the point? Long-term interest rates are already low. There’s clearly scope for more fiscal stimulus, but the public mood is against it and it would be nearly impossible to get anything significant through Congress. The desire to reduce the budget deficit is well-intentioned, but misguided in the short term. As a consequence, the economic recovery may be painfully slow in the quarters (perhaps years) ahead.

The Gulf oil spill had a clear impact on consumer confidence numbers in June and may dampen consumer spending growth in the near term. If households increase savings significantly (which might happen after a drop in the stock market), overall growth will be even softer. Businesses generally remain fearful of what the Obama Administration might do, but Obama has already had difficulties getting things through Congress (healthcare and financial reforms were significantly watered down). The November elections won’t change that outlook, but it could alter perceptions. Normally, gridlock is good for the markets, but there are times when stuff has to get done.

Copyright (c) Raymond James Equity Research

Tags: Animal Spirits, Consumer Spending, Double Dip Recession, Dr Scott, Economic Data Releases, Economic Expectations, Economic Outlook, Employment Report, Equity Research, Fiscal Stimulus, Growth Outlook, Labor Force Participation, Peculiarities, Population Ratio, Raymond James, Seasonal Adjustment, Significant Improvement, Sustainable Recovery, Unemployment Insurance Benefits, Unemployment Rate
Posted in Energy & Natural Resources, Markets, Oil and Gas, Outlook | Comments Off

Stock Market Valuation is Stretched on Long-term Basis

Tuesday, March 16th, 2010

With the S&P 500 Index and a number of other benchmark stock market indices flirting with cycle highs, I will be monitoring things very closely over the next few days to see if the market’s overbought condition spells more downside potential than an expected consolidation. Or will the Index surprise us and fly trough the 1,151 area?

In addition to being overbought, the S&P 500 is also now expensively valued on a long-term cyclically adjusted PE (CAPE) basis, according to Robert Shiller, economics professor at Yale and author of, among others, Animal Spirits, Subprime Solution and Irrational Exuberance.

In order not to work with notoriously unreliable forward-looking earnings estimates, I have always preferred using Shiller’s CAPE methodology, or normalised earnings, as they average ten years of earnings. This measure provides a good picture of the market’s value regardless of where we are in the business cycle. I have therefore been updating a CAPE chart for a number of years. On this basis, the multiple has increased to 20.5 since the March low of 13.3, representing an overvaluation of 25.0% when compared to a long-term average of 16.4.

“Where breadth goes, the market usually follows,” goes an old market saying. Breadth indicators are useful tools to assess the inner workings of the market’s rallies or corrections, and are used to identify strength or weakness behind market moves, i.e. to assess how the bulls and the bears are exerting themselves.

One such measure is net new highs, calculated by subtracting the number of new 52-week lows from the number of new 52-week highs (see top pane in the chart below). This indicator often peaks before the price index, as was the case in November. It has also been falling sharply over the past few days. Is this again a precursor to a lower S&P 500 (bottom pane)?

Source: StockCharts.com

I stand by my summary in my Words from the Wise review on Sunday: Although the fat lady has not yet made her appearance to signal the end of the bull cycle, the steepness of the nascent rally, together with resistance in the area of the January highs, could result in stock markets consolidating in order to work off a short-term overbought condition. On the fundamental front, tighter money does not necessarily spell a declining stock market, but turning off the “juice” will certainly remove a tailwind, making earnings growth the key determinant for generating further gains (especially in light of stretched valuations).

Tags: 52 Week Highs, 52 Week Lows, Animal Spirits, Bottom Pane, Breadth, Business Cycle, Earnings Estimates, Economics Professor, Inner Workings, Irrational Exuberance, Market Moves, New 52 Week Highs, New 52 Week Lows, New Highs, Normalised, Price Index, Robert Shiller, Stock Market Indices, Stock Market Valuation, Term Basis
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Shiller: Stocks fairly valued but could “go down a lot”

Tuesday, July 14th, 2009

With the S&P 500 Index after yesterday’s surge again slightly above the “neckline” (of the head-and-shoulders formation referred in a post last week), I will be monitoring things very closely over the next day or two to see if the impressive bounce was just a one-day wonder or something more enduring.

Meanwhile, the S&P 500 is now fairly valued on a long-term cyclically adjusted P/E (CAPE) basis, according to Robert Shiller (as reported by Yahoo Finance, Tech Ticker). Shiller is economics professor at Yale and author of, among others, Animal Spirits, Subprime Solution and Irrational Exuberance.

In order not to work with notoriously unreliable forward-looking earnings estimates, I have always preferred using Shiller’s CAPE methodology, or normalised earnings, as they average ten years of earnings. This measure provides a good picture of the market’s value regardless of where we are in the business cycle. I have therefore been updating a CAPE chart for a number of years. On this basis, the multiple increased to 15.8 during the March-May rally, representing “neutral” value when compared to a long-term average of 16.3.

According to Yahoo Finance, Tech Ticker, Shiller is skeptical of the “green shoots” viewpoint and is of the opinion that it would take a considerable period of time for the economy to return to normal growth. Although the stock market’s neutral valuation implies a long-term average return of 7%, he is not forecasting that outcome due to the “precarious state” of the economy that could stumble anew and cause stocks to “go down a lot”.

As mentioned in my “Words from the Wise” post on Sunday, the stock market technicals undoubtedly look ugly and investors will now focus on the second-quarter earnings reports as a test of whether stock prices have run away from fundamental reality. While investors wait for Mr Market to show his hand, a cautious approach is warranted, but that should not preclude one from finding stocks that look cheap.

Click on the image below to view Aaron Task’s interview with the famed professor.

Source: Yahoo Finance, Tech Ticker, July 10, 2009.

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Tags: Animal Spirits, Business Cycle, Cautious Approach, Earnings Estimates, Earnings Reports, Economics Professor, Fundamental Reality, Head And Shoulders, Irrational Exuberance, Methodology, Neckline, Normalised, Period Of Time, Precarious State, Robert Shiller, Second Quarter Earnings, Stock Market, Stock Prices, Viewpoint, Yahoo Finance
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